Should I Loan Money to My Business?

Question: Should I Loan Money to My Business or Invest Money in My Business?

As a new business owner, you will probably need to put money into your business from your personal savings. Even if you don't need a bank loan, you'll need what is called an "infusion of capital" or a capital contribution to get the business started.

Even if you can get money from friends or family, or from a lender, you will need to put some of your own money into the business. If you are joining a partnership, a capital contribution is usually required. A lender will want to see that you have some of your own collateral (some of your own personal money) as a stake in the business.

But should that money be a loan to your business or an investment? There are tax implications for each situation.

Making a Loan to your Business

If you want to loan money to your business, you should have your attorney draw up paperwork to define the terms of the loan, including repayment and consequences for non-repayment of the loan. It should be clear that the loan is a binding obligation on the part of the company. As a recent Tax Court case notes, the absence of such paperwork negates the loan and causes

For tax purposes, a loan from you to your business is an "arms length" transaction, being treated like any other debt. The interest on the debt is deductible to the corporation, and taxable to you personally as income. The principal is not deductible to the business unless it uses the funds to purchase capital assets (which qualify for depreciation deductions.)The return of principal on the loan is not taxable to you, since the loan was after-tax money.

Making an Investment in your Business

The other option for putting money in your business is to invest the money. In this case, the funds go into your owners equity account (for a sole proprietorship or partnership) or into retained earnings (for a corporation). If you withdraw your contribution, there is no tax consequence to you. If you withdraw additional money in the form of bonuses, dividends, or draw, you will be taxed on these amounts. There is no tax consequence to the business on this investment, except in their use of the funds to purchase depreciable assets.

The borrower's (the company's) ability to obtain loans from outside lenders.

In any case, it is important for you to designate your contribution as either a loan (with the required paperwork) or capital investment, so that the tax implications of the transaction are clear and you avoid any problems with the IRS.

Loan vs. invest: Risks Compared

Each of these decisions carries risk. If you loan the money to the business and the business declares bankruptcy, you become a creditor. Depending on whether the loan was secured or unsecured (with collateral), you may or may not be able to get your money back from a liquidation. If t

On the other hand, in the case of a bankruptcy the owner's investment is entirely at risk and there is little or no possibility for returning those funds to you.

Disclaimer: The information in this article is intended to be general and is not tax or legal advice. Before you make a decision on whether to loan money to your business or invest in stock, talk to your tax attorney, or financial advisor.